Over the last two years it’s risen 47% — and in 2013 alone the index surged nearly 32%. That sprint is far ahead of the historic ~10% average yearly gains the index has made since inception.Looking at the cyclically adjusted PE of the S&P 500 is sobering.

The price of the market is just a hair short of the 2007 high of nearly 27x earnings reached in July of that year. This high is well above the historic average of 16.5x earnings and speaks volumes about current market sentiment.

While the stock market pretends that all is well, the economy continues to sputter.

Unemployment figures are down over the last couple years as mobs of people have decided that participation in the never-ending arms race of higher education is their best bet after being forced out of the labor force.

Legions of 4 or 6 year college graduates have swarmed online employment sites and now stand behind counters asking you whether you want paper or plastic.

Full time work has been replaced with part time or contract work and everybody but the crem de la crem seem to be taking home less in absolute or inflation adjusted dollars.

“…we also have the re-emergence of the Russian empire to contend with, under the leadership of Prince Putin…”

While the urgency of the credit crisis is now 4 years behind us, the situation is no less dire.

There’s a lot of talk in the media of deleveraging but little evidence for it. The ideological fools on capital hill, in the most indebted nation in the history of the world, seem more interested in bickering over small ideological differences than making real changes that are desperately needed.

American gross national debt stood at just over $10 trillion in 2008, but has risen to over $16.7 trillion as of June 2013. GDP, on the other hand, was estimated to be $17.1 trillion in December 2013.

Greece is a mess with a debt that’s risen from 105% of GDP in 2008 to 157% today. Spain, Italy, France, Britian… Even Germany is struggling with a national debt that’s topping 81% of GDP. So much for the saviour of the Eurozone?

And those are just a few economic pain points — we also have the re-emergence of the Russian empire to contend with, under the leadership of Prince Putin, and the inevitable economic fallout that would come with escalating the crisis. As of 2014, Russia accounts for nearly 30% of Europe’s energy and this could come into play if sanctions are imposed on Russia.

Yet somehow investors feel confident enough to push the stock market’s PE to 25.4 — a hair under the high reached back in 2007?

This insanity has to stop.

It’s no secret what happened to investors who gorged themselves back in 2007.

The pigs got slaughtered.

It’s the same thing that happened back in 2000 during the new wave economy and greedy investors pushed the averages up to depressingly high levels.The pigs got slaughtered.

Any time investors get carried away and prices get divorced from fundamentals, nasty things happen.

So what is your plan?

The cowardly may feel compelled to sell all of their holdings, get out their crash helmets, and brace for impact. This isn’t the best course of action to take.

Here’s the thing — even after all of that, the stock market still does not have to go down.

It’s foolish to predict the direction of the stock market — even with the mess that we’re seeing in early 2014! Alan Greenspan, former chief wizard at the Federal Reserve, once quipped that economic forecasting was better than a flip of a coin but not by much.

Generally there are three paths that the market can take:

The market can go up

The market can go down

The market can go sideways

Given our current global economic and political situation, the cards are definitely stacked against favorable returns going forward …but what actually unfolds can’t be known in advance.

Despite the danger and uncertainty we face as value investors I do believe that we can drastically reduce our risk exposure while still leaving the possibility open to achieving adequate returns going forward.

So what should you do?

Let’s look at the four most practical options available to you. You don’t need to be an experienced Wall Street trader to take advantage of any of them — you can adopt them from the comfort of your tablet at home:

A. Business As Usual

The business as usual approach is simple: just invest as usual, ignoring current valuations, economic issues, and political problems.

Depending how you invest, this might be a good option for you. But if you’re buying value stocks based on current earnings, cash flow, or future projections… look out below!

When markets tumble they take fairly-valued or overvalued stocks down to ridiculously cheap levels. If your portfolio is made up of these kinds of stocks…. well…

It could take you decades to recover from losses suffered after buying stocks trading at only a shallow discount to fair value based on current artificially inflated earnings.

B. Sell it All and Hide in Cash

This strategy has some pretty significant benefits and drawbacks. Being in cash would eliminate the risk that your entire portfolio would be pulled down with the stock market.

The problem is, the market might not collapse — this is that whole unpredictability thing I mentioned earlier. It means that while the value of your savings slowly erodes due to inflation, stocks could continue to rise, or could possibly go sideways while fundamentals improve. Worse, if the economy got significantly better, not only would you be out of the rally but you could possibly face significant inflation.

C. Buy Bitcoin

This is the strategy that I’ve elected to take. The idea is simple: you stick to rigorous investment standards that have been proven successful over time, buying firms at significant discounts to a conservative estimate of intrinsic value, and keep the rest in cash as you wait for more opportunities.

The cash in your portfolio acts as valuable insurance against a market collapse and gives you significant leverage during a massive market downturn.

When the market crashes you could help end the pain of paper losses that some investors suffer by exchanging their shares for an unbearably small amount of cash.

The key to this strategy, though, is maintaining a very strict buy discipline — such as I do using my NCAV scorecard. This should keep the number of picks in your portfolio modest, and cash bountiful.

The companies that you buy should be very cheap yet conservatively financed, such as the stocks I suggest to those who opted to get free NCAV stock ideas.

I try to buy when a stock is trading for less than half of its NCAV. A discount this steep means that, not only is there a significant chance for large capital gains but, my stocks should be partly buffered from large market drops.

You could call this the insurance strategy, as it insures against both the risk of holding all cash and the risk of an all stock portfolio when the market turns. Owning well-chosen deep value stocks means you have a great chance of seeing significant profits that will pull up the rest of your portfolio if the market goes sideways or up.

Owning a comparatively small number of ultra-cheap stocks means smaller losses during a crash since your holdings are already dramatically depressed and the rest of your portfolio is made up of cash.

What’s the right split between cash and stocks?

That really comes down to how many great opportunities you find in the market.

Right now deep value investors who have failed to look for stocks outside of their home country are feeling a lot of pain.

Sophisticated value investors, by contrast, are starting to wake up to the fact that it doesn’t make sense to spend time building a portfolio of value stocks only to ruin it by not including the best opportunities available — so many of these investors have chosen to look for stocks in friendly international markets.

I, myself, have holdings in Australia, America, Canada, and Japan. In Australia, I found an industry that has taken a hammering not seen since the depths of 2008. In Japan, one of my net net stocks is debt-free, has improved earnings over the last 4 years, and currently trades at a PE of 6x earnings!

While the market as a whole is extremely expensive, looking internationally ultimately means finding more great investment candidates that fit your strict buy criteria.

(Hint: Opt for option “D”)

There’s only one or two great opportunities available in any one western market these days; and I should know… it’s what I do.

Oddly enough, if you open your investment universe to include a range of friendly foreign markets, you suddenly have a lot more investment opportunities available. This is why forward thinking value investors have started to hunt for deep value stocks in international markets and why I recommend that you should, as well.

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6 responses to “Is This The Year You Lose Your Entire Life Savings?”

What is your view about hedging the currency risk when implementing option D? As usual, there are studies proving both ways, some with the conclusion that it is worth hedging (as you could end up where you started 10 years ago) and others which tend to agree that if your time horizon is really really long, hedging wouldn’t make much difference.

My overall opinion is that investing is hard enough without adding any additional complications. It really amazes me that the more knowledgable/sophisticated investors get the more they insist on investing in increasingly complex situations rather than just looking at simple tactics and strategies that have been shown to work very well over time.

With net nets specifically, the average annual return over the market has been shown to be roughly ~15% per year…. if you just put a mechanical buy and hold portfolio together. Typical returns have been shown to be anywhere from 20-35% per year over the long term while the market returns ~10%. If you hedge your portfolio by shorting the market than you would end up losing ~10% on average on your hedge over the long term. That would reduce your portfolio returns to roughly 10-15% YoY.

If you only hedge when the market is expensive then you might have a different experience, however I don’t think people can accurately predict the direction of the market so I don’t think market timing your hedge is smart. At best, I could see it not adding any value to your portfolio over the long term — though others would likely disagree with me.

I got a great email from a really friendly deep value American investor who had a couple objections. I wanted to lay them out here with my responses because some other investors might feel the same way:

1. “…many of these stocks are not traded as ADR’s and investors like me do not have access to them…”

Me: I use interactive brokers which is available to Americans and offers very cheap international trades. They have very inexpensive trades — far less expensive than Fidelity. Trades really are inexpensive and order execution seems good. Really, there’s no reason to use another broker… but here are 5 other international brokers open to Americans:

2. “…when you own foreign shares, especially in taxable accounts instead of tax deferred, tax returns become more complex…”

Me: Since I’m not American, I can’t speak to American tax issues. That being said, if you get your taxes done through an accountant than it shouldn’t really be an issue — at least it hasn’t been for me in Canada.

One more note: Even with any additional costs, the additional capital gains that you would inevitably see from holding great deep value investments would more than make it worthwhile.

I see what you mean. I was not even considering hedging a whole portfolio against the market risk, but thinking about the currencies of the countries where you are investing (e.g. if you invest in Japan from Canada, then hedge the CAD-JPY currency pair so that you’re just expose to the Japanese stock market and not to the forex movement between the 2 currencies as well).

If one has an international portfolio, keeping on top of all variables seems quite complex indeed, but when one see historical FX graphs (where currencies sometimes have a 15-30% movement per year), it makes you think when it’s a good moment to invest abroad. It seems that if you’re doing it when your local currency is really weak you could end up losing on the FX movement more than what you get in your foreign stocks.

GBP has been really week for the last 5 years for example, after ~30% decline against most other currencies back in 2008, so investing abroad from the UK adds an extra layer of risk (and initial cost when you invest in a stronger currency).

I haven’t seen convincing evidence one way or another. I have read that hedging helps, and I’ve also read that — over the long term — hedging international currencies doesn’t add much value at all.

If you invest in a range of markets then you would expect things to balance out — though I’m open to being convinced otherwise. Conversely, if you just invest in your own country then you’re placing a big bet on your own currency.

Yes true enough. But, net nets are found mostly in down markets which typically means economic issues in the associated country. Generally that also means that the currency is weak in that country, so you end up buying a lot into depressed currencies.

Also, since most of your portfolio would be outside of your home country, you’d bypass the issue of buying foreign currencies when yours is weak.

And then, even if you could tell that your currency is weak, you may not have a clue when that will change, but you’d miss out on great stock opportunities while you’re waiting.

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